“Wall Street is sounding a lot like Miami Beach, what with all the talk of attractive models. But the Street’s models aren’t pouting, underfed teenagers. They’re analytical schemes for evaluating the stock market, and right now many of them are showing stocks to be a screaming buy, even after the recent rallies,” writes Michael Santoli in this week’s Barron’s.

“The challenge for the investor, however, is to take a close look at these alluring models to determine whether they can be trusted with precious investment dollars in a market where many indicators are more superficial than substantive.”

“The most widely cited market valuation method, known as the Fed Model, has leapt from obscurity to ubiquity in the past five years. These days, this model is being hoisted like a battle flag by Wall Street strategists because it shows the stock market to be more than 25% undervalued, providing analytical support for a bullish stance on stocks. Described in a 1997 Federal Reserve document, the model enjoys the aura of official endorsement, even if Alan Greenspan and his lieutenants have never explicitly blessed it.”

“The model compares the earnings yield of the S&P 500 (defined as the forecast earnings for the next 12 months divided by the S&P 500 index level) to the current yield on the 10-year Treasury note. It considers ‘fair value’ to be the point at which the earnings yield equals the Treasury yield. When the earnings yield exceeds the Treasury rate, stocks are said to be undervalued. Stocks are deemed overpriced when the bond yield is higher.”

“Other systems that plumb the relationship between stock prices, earnings and interest rates are coming up with similar conclusions. Investment strategist Byron Wien at Morgan Stanley keeps a dividend-discount model that employs many of the same inputs as the Fed model, while adding a factor to account for the added risk in owning stocks as opposed to government bonds. This indicator has been deep in buy territory since April. It showed stocks to be 32% undervalued in the middle of last week.”

“Using another indicator, the ISI Group last week highlighted an approach credited to Clyde Bartter of Boyd Watterson Asset Management, which holds that since the 1960s, the price-to-earnings ratio on the S&P 500 has tracked the inverse of the prime borrowing rate. With the prime now at 4.75%, and its inverse at 21, it implies that stocks should be trading at 21 times earnings, well above the present level of 17 times 2002 earnings.”

“Other approaches include comparing the present dividend yield of the S&P 500 to prevailing money-market rates. Stocks have not held such a large yield advantage over short-term cash rates in some 20 years — yet another angle from which to cast an optimistic glance toward stocks at current levels.”

“All such market-evaluation methods aim to determine whether owning the variable and risky earnings streams of stocks is worthwhile, when compared to the safe and static income and assured return of capital from bonds. At the moment, the collective wisdom of these approaches suggests that the odds have tilted sharply in favor of stocks.”